2018 Issue 21 Issue THE BURGUNDY Tencent: Game Over or Level Up? The global market for video games has expanded rapidly over the past decade spurred by advances in mobile connectivity and smartphone technology. The size of the industry is estimated to be USD 140 bn and has allowed Naspers, through its investment in leading game company Tencent, to become the largest company on the JSE. Recently, both stocks were sold down severely by the market amidst a weak second quarter result in Tencent’s gaming business. The weakness was driven by a clampdown on video games by Chinese regulators. This prompted many to ask whether the result marks the end of an impressive growth story. An escalating trade war between the US and China adds further fuel to these concerns. This report asks whether it really is “Game Over” by shedding light on the game industry in China and Tencent’s prospects going forward. 21 Fricker Road, Illovo, Jhb, 2196 +27 11 772 2480 [email protected] A Tumultuous Year for Tencent The year 2018 has been a turbulent one for Tencent as demonstrated by its share price which has fallen 23% in the year and 34% from its peak in USD terms. Naspers, the largest stock on the JSE through its 31% interest in Tencent, has followed suit falling 29% in the year and 26% from its peak in US Dollar terms (as at 6 Sep, 2018). By virtue of being c. 20% of the All Share Index, Naspers is a mainstay in many retirement portfolios and significantly influences the retirement savings of most South Africans. Furthermore, Naspers and Tencent together represent more than 6% of the MSCI Emerging Markets index. Figure 1: Indexed Price Return in USD, Tencent and Naspers, 2014-Current (6 Sep, 2018) 500 Tencent (USD) Naspers (USD) 400 300 200 100 0 Dec-2013 Dec-2014 Dec-2015 Dec-2016 Dec-2017 The sharp fall in stock price was due to a rare earnings miss by Tencent – its first in nearly 13 years. As shown below, earnings per share fell 2% YoY and 23% QoQ despite revenue growing 30% YoY (Figure 2). The weakness came from its video game business which is facing increasing Government scrutiny in China. A sector wide freeze in awarding licenses for new games has been in place since March due to the restructure of a regulatory body. Authorities are further seeking to limit the number of hours minors spend playing games and limit the total number of games operating in the market. The crackdown has severely affected Tencent’s hit game, PlayerUnknowns’ Battleground (PUBG), which could not be monetised despite topping the charts in terms of number of active game players. Figure 2: Quarterly Tencent Revenue (LHS) and Earnings per Share (RHS) 80 3 70 60 2 50 40 30 1 RMB per RMBper Share Bn Bn RMB 20 10 0 0 Dec Mar Jun Sep Dec Mar Jun Sep Dec Mar Jun Sep Dec Mar Jun Sep Dec Mar Jun 13 14 14 14 14 15 15 15 15 16 16 16 16 17 17 17 17 18 18 Revenue Earnings per Share 1 Despite the regulatory pressure, Tencent’s operating metrics within its gaming business appear to be stronger than ever. It is well represented in the top 10 rankings both globally across Personal Computer (“PC”) games and locally within the Chinese Appstore (see Table 1). Engagement within its games measured by monthly active users has been growing at double digits. The only pressure point has been that monetisation per user has declined due to a delay in obtaining regulatory permits. Table 1: Global PC Game Rankings and China iOS Store Rankings (July, 2018) Rank Most Popular PC Games: Global Highest Grossing iOS Mobile Games: China 1 League of Legends Honor of Kings 2 Fortnite Fantasy Westward Journey 3 Hearthstone: Heroes of Warcraft 自由幻想 4 PlayerUnknown's Battleground QQ Speed Mobile 5 Counter-Strike: Global Offensive Chu Liu Xiang 6 Minecraft Fantasy Westward Journey 2 7 Overwatch King of Chaos 8 World of Warcraft Legacy TLBB Mobile 9 Tom Clancy's Rainbow Six: Siege New Ghost 10 Grand Theft Auto V JX Mobile Tencent Subsidiary developed game Tencent Investee developed game Source: Newzoo The key question is whether the industry profit pool of Tencent’s most profitable segment, video games, will structurally decline from here on due to the escalating regulatory pressure. If so, it will indeed be “game over”, especially with the high expectations placed on Tencent at a 33x PE multiple. In the sections that follow, we provide a brief primer of the Chinese game industry and share our perspective on how recent developments will affect Tencent’s future prospects. Investing in Video Games, Really? Clients often express a degree of disbelief when we explain to them that a company which generates the majority of its revenue stream from video games is also the biggest constituent of the JSE and a sizable holding in our fund. On one occasion, a client even remarked: “But gaming is so fickle” and another could not understand how such companies make money, let alone achieve a larger market cap than global juggernauts such as British American Tobacco and Coca Cola. 2 However, video games are indeed a significant business. Globally, the industry is worth c. USD 140b and is one of the fastest growing categories in the USD 2 trillion media and entertainment industry (see Figure 3). It has already overtaken the movie industry (USD 41b), radio industry (c. 52b) and recorded music industry (USD 17b) in size. Mobile games account for much of this growth and represents approximately half of the game industry’s revenue. Rising smartphone penetration has expanded the addressable market to a broader demographic far in excess of the legacy PC and console game market. Today, games are played across more age groups, sexes, nationalities and income groups than ever in the history. The gaming population has expanded to c. 2b people which is its highest point in the industry’s history. Figure 3: Global Game Industry Revenue Size (excluding Equipment Revenue) 150 Mobile Games Global Games 100 50 0 2012 2013 2014 2015 2016 2017 2018F Source: Newzoo Table 2: Video Game Market Statistics (June, 2018) Total Population Internet Smartphone Rank Country / Market Revenue (M) Population Penetration (Mn USD) 1 China 1,415 850 55.6% 37,945 2 USA 327 265 71.5% 30,411 3 Japan 127 121 51.9% 19,231 4 Republic of Korea 51 48 72.9% 5,647 5 Germany 82 76 71.0% 4,687 6 United Kingdom 67 64 70.8% 4,453 7 France 65 58 67.8% 3,131 8 Canada 37 34 71.8% 2,303 9 Spain 46 39 69.5% 2,032 10 Italy 59 40 68.5% 2,017 Source: Newzoo 3 As shown in Table 2, China is the biggest market in the world and the most attractive for game developers. It is bigger than the US in terms of size, growth rates and number of gamers. The Chinese game population with 620 million players is bigger than many countries in the world and spends USD 38b on games. It is expected to continue growing due to the low smartphone penetration in country. Cornering the Chinese Game Market Roughly 70% of spend on games in China is allocated towards locally developed games1 making the country one of the most insular markets in the world. This is, in part, because foreign developers are required by law to utilise a local publisher to distribute their games in country. Within this context, companies such as Tencent and NetEase have built thriving enterprises by developing their own content and also playing the role of distributor for foreign game developers. The dominance is demonstrated by both the consistency with which they produce top 10 hit games (Figure 4), and their combined market share of c. 66% of the industry’s revenue (Figure 5). Furthermore, this share has been increasing which implies that larger players are consolidating the overall market into a duopoly. Figure 4: Number of iOS top 10 Grossing Games – Tencent vs. NetEase 7 Tencent 6 Netease 5 4 3 2 1 0 Jul 15 Jul 16 Jul 17 Jan15 Jan16 Jan17 Jan18 Sep 15 Sep 16 Sep 17 Nov 14 Nov 15 Nov 16 Nov 17 Mar15 Mar16 Mar17 Mar18 May 16 May 17 May 15 Source: HSBC, SensorTower Figure 5: Online Game Revenue Market Share, Tencent and NetEase 70% Tencent NetEase 60% 50% 40% 30% 20% 10% 0% 2009 2010 2011 2012 2013 2014 2015 2016 2017 Source: China Audio and Video Association Game Industry Committee (GPC), Company Reports 1 Atomico.com 4 Such consistent market dominance is rarely possible without a strong competitive advantage over competitors. To understand the drivers of this economic moat, one has to appreciate first that the majority of games in China are played online (mobile and PC). Console games never really penetrated the Chinese market as they were banned until 2014 and are highly prone to software piracy. As a result, online games became popular as a means of avoiding piracy. This resulted in a wide proliferation of free-to-play or freemium games where monetization takes place by purchasing items within the game (e.g., customisations, weapons, etc.). Interestingly, this model has more recently gained popularity in other parts of the world due to the rise of multi- player gaming and mobile appstores. In simple terms, the economics of a profitable video game require the following equation to be true: Customer Lifetime Value > Cost per install The left hand side of the equation is driven by the duration over which a game can retain a player’s attention.